Hedge Funds Dump Stocks, Hoping for Rebound in 2012

Frustrated by market volatility over the European debt crisisand uncertain U.S. economic outlook, the so-called smart money—hedge funds—has thrown in the towel for 2011 and pulled out of stocks, according to fund managers, SEC filings and exchange data.

Timothy A. Clary | AFP | Getty Images

A concerned trader on the floor of the New York Stock Exchange.

Hedge fundshave slashed their exposure to stocks—both on a long and short basis—to the lowest level since 2008, according to Bank of America Merrill Lynch analysis of SEC disclosures and NYSE and Nasdaq data.

Their net long exposure to stocks plummeted by more than a third, the biggest drop since 2009, stated the report by analyst Mary Ann Bartels entitled “Hold ‘em and Fold ‘em.”

But hedge funds are clearly as worn out by gyrating markets as everyone else.

“The uncertainty coming from the Eurozone has created an environment where almost all asset classes have traded in tandem and fundamental analysis has been almost irrelevant,” said Michael Murphy, CEO of hedge fund Rosecliff Capital. “The very analysis that hedge funds rely on has become secondary to the headlines coming out of Europe on a daily basis.”

Whipsawed by stubborn high unemployment figures and a vicious debt ceiling debate in the U.S. and then a credit crisis cluster bomb in Greece, stocks began to fall apart on the year at the start of August, falling to new lows.

Shares rebounded a bit, only to fall to an even deeper low for the year at the start of October. A rally ensued the rest of that month as investors bet on a successful execution of some sort of European bailout fund.

“The rally in October was a worst case scenario,” added Murphy. “It brought the S&P back to the black for 2011. A lot of funds were extremely hedged or net short due to the global uncertainty.”

This month, stocks have fallen back below breakeven for 2011 as uncertainty over the size of the European bailout grows and a failed bipartisan agreement to cut the U.S. deficit points to more political infighting next year. Wednesday's market rally, fueled by hopes that Europe's debt crisis may not get any worse, has made investing even more confusing.

Hedge funds have paid the price. The HFRX Global Hedge Fund Index—compiled by industry observer Hedge Fund Research—is down 9.9 percent for 2011 through the end of last week. The S&P 500 is still negative on the year—even with Wednesday's rally—and the majority of global markets are the same.

Bartels' research report also showed that hedge funds raised their cash levels to 6.8 percent. They cut their exposure to the financial and industrial sectors by half. These would be among the hardest hit if the Euro falls apart, sparking a financial crisis that grinds global growth to a halt.

Favorite positions among hedge funds were gold , Treasurys and sectors with inelastic earnings streams such as pharmaceuticals and staples , according to Bank of America Merrill Lynch.

“Volatility plus correlation equals no liquidity,” said Alec Levine, an equity derivatives strategist with Newedge Group SA. “It is very hard to find an economically viable hedge—they become too expensive and eat up too much of your potential return. Welcome to the ‘live to fight another day’ market.”

For hedge funds, that day will be Jan. 1.

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